“We Are 90% Through The Cycle”: David Rosenberg’s 2018 Outlook

From David Rosenberg of Gluskin Sheff

As we take out the crystal ball once again to provide our forecasts for the year ahead, it pays to drum up the old adage that to know where you are going you have to know where you have been.

With that in mind, I have to wonder what it means to be heading into a new year with the global economy in sync, the Fed tightening policy, the U.S. Treasury curve flattening, the equity markets hitting new highs, the credit cycle peaking out, extremely low volatility and investor complacency equally high, excessive valuations across most asset classes, and a U.S. labour market that is drum tight. As I dig into my memory bank, this backdrop is eerily similar to 1988, 1999, and 2006. And what we know about each of those years is that the one that followed was the last of the cycle.

So if the past is a precedent, we had better enjoy the next twelve months. The economic expansion and bull market won’t necessarily end in 2018, but they will be on their last legs, nonetheless. Expect strains to emerge as the lags from the tightening in Fed policy expose the excesses in various corners of the financial markets. Constantly thinking of how to invest late in the cycle is the most prudent advice we can give, and how we are positioning our asset mix and portfolios.

Ten Late-Cycle Signposts

• Expansion turning nine in June
• Full employment
• Decade-low savings rate
• Cycle-high consumer confidence
• Fed tightening
• Flattening yield curve
• Excessive P/E multiples
• Very tight credit spreads
• M&A boom
• Peak autos/housing

We also have a new and untested Federal Reserve (with a virtually unprecedented four of seven Governor seats on the Federal Open Market Committee (FOMC) vacant at the moment), midterm elections looming in the United States (where the Democrats stand a reasonably good chance of retaking the House), ongoing investigations into the Trump team, and questions over how tax reform will play out as well as the central bank’s reaction to the stimulus. Not only do we have a relatively inexperienced Fed given that it just lost a combined 35 years of monetary policymaking with the departures of Yellen, Fischer and Dudley, but only three FOMC members are still around from the group that built up the now bloated balance sheet nine years ago. So we have a crew dismantling the balance sheet who simply lack the knowledge and gravitas of Ben and Janet, it will be interesting to see if a policy misstep awaits us in 2018. The history of new Fed chairs is that they overtighten — Volcker (1979), Greenspan (1987) and Bernanke (2006) — and we know what history says about the consequences, whether they are economic, financial, or both.

The Bank of Canada (BoC) and the Bank of England (BoE) have already joined the Fed on the path towards higher interest rates, though it remains unclear how much more these monetary authorities will follow suit. It looks like U.S. monetary policy is on autopilot, even though we are just two rate hikes away from an inverted yield curve. At the same time, while the reduction in the size of the balance sheet is gradual for now, by the end of 2018 enough will have been done to be equivalent to taking out two-thirds of the first round of quantitative easing. If you recall, this had a major impact in reviving the economy and stimulating investor risk appetite. So it would stand to reason that we will see the movie run in reverse this coming year. And fiscal stimulus will only compound the negative implications for Fed liquidity if it causes any further tightening in a labour market that has already hit the proverbial wall.

The European Central Bank (ECB) will be set to announce a new president, and it looks as though the job will go to a German this time, not an Italian, so the contours of global monetary policy are set to shift and with important implications for market liquidity. As things stand, the central bank is looking to gradually remove stimulus, but a new more hawkish ECB President could well accelerate this process. Perhaps one of the greatest risks for 2018 will be a global melt-up in German bund yields. We saw a small template of what this looks like, and the spillover globally, when the 10-year bund yield surged from 0.15% to 0.60% in the first half of 2017.

While Emmanuel Macron remains on course with his impressive economic reforms in France, the otherwise constructive developments on this front have been blunted somewhat by the political uncertainty in Germany, and the ongoing clouds over the Brexit negotiations. The prospect of an abrogation of NAFTA is another source of uncertainty, especially with respect to supply chains in North America, with negative implications for the auto sector, consumer staples and agriculture.

Last but not least, we have China, whose economy has recently begun to display some slowing signposts and whose government officials are beginning to become less accommodative towards the highly indebted state-owned government sector. That said, we are encouraged about the continued shift to consumption from fixed asset investment, underscored by the success of Alibaba and other e-commerce companies in China. These are helping in the previously stated goal of rebalancing the economy. In the coming year, we will be watching the supply side in China very carefully to see if the Xi government will promote the reduction in outdated capacity.

In other words, expect a year where volatility re-emerges as an investable theme, after spending much of 2017 so dormant that you have to go back to the mid-1960s to find the last annual period of such an eerie calm — look for some mean reversion on this file in the coming year. This actually would be a good thing in terms of opening up some buying opportunities, but taking advantage of these opportunities will require having some dry powder on hand.

In terms of our highest conviction calls, given that we are coming off the 101 month anniversary of this economic cycle, the third longest ever and almost double what is normal, it is safe to say that we are pretty late in the game. The question is just how late. We did some research looking at an array of market and macro variables and concluded that we are about 90% through, which means we are somewhere past the 7th inning stretch in baseball parlance but not yet at the bottom of the 9th. The high-conviction message here is that we have entered a phase of the cycle in which one should be very mindful of risk, bolstering the quality of the portfolio, and focusing on strong balance sheets, minimal refinancing risk and companies with high earnings visibility and predictability, and low correlations to U.S. GDP. In other words, the exact opposite of how to be positioned in the early innings of the cycle where it is perfectly appropriate to be extremely pro-cyclical.

So it’s either about investing around late-cycle thematics in North America or it is about heading to other geographies that are closer to mid-cycle — and that would include Europe, segments of the Emerging Market space where the fundamentals have really improved, and also Japan. These markets are not only mid-cycle, and as such have a longer runway for growth, but also trade relatively inexpensively in a world where value is scarce.

I would have to say that if there is a market that has broken out of a 25-year secular downtrend and where the economic and political tailwinds are significant, it is Japan. I get told all the time that Japan’s population is declining, but we are buying companies, not bodies, and the bottom line is that even with this declining population, earnings momentum is on the rise and profit margins are on an impressive expansion phase, and not nearly priced in. In fact, Japan is one of the few markets globally that is not trading at premium multiples relative to its history and is an under-owned market both globally and locally. Moreover, an important part of Prime Minister Abe’s strategy is to improve corporate governance in Japan, and there are signs of early success as cash comes off corporate balance sheets and a rising number of companies are putting non-Japanese executives on their boards. This is one of the catalysts that has driven margins to multi-decade highs. We are searching for companies that have the balance sheet and cash flow yield that would prompt management to increase payouts through rising dividends and, more importantly, share buybacks.

Turning to Canada, there is some visibility here in the oil price given the following developments: the high degree of OPEC compliance; the drawdown in U.S. inventories; declines in global storage; solid world demand, especially from oil-hungry emerging markets; and a geopolitical risk premium coming back into the market. The shape of the oil curve doesn’t lie and the recent move from contango to backwardation is an added sign of how tight the crude market has become. The beauty here is that the Canadian E&P stocks are not priced for where oil is today, testing $60 per barrel for WTI, and over the near term there is more upside potential than downside risk. So they look attractively priced here, once again in a world where inexpensive assets are in short supply. And given the correlations between energy and the Canadian banks, this is good news for this sector as well.

It also seems to me that with the Bank of Canada remaining accommodative and with the Fed likely to raise rates, there are increased odds of the Canadian dollar faltering. And let’s face it, the economy here is going to need another dose of some currency-related stimulus because of the combination of NAFTA uncertainty, the tightened B20 mortgage regulations (which is sure to bite into the housing market next year), and a clouded fiscal picture in terms of the outlook for taxation (I have no clue as to why the federal government is adding more complexity to this situation, but it is just another reason for the Bank of Canada to stay on the sidelines).

In any event, the resultant weakening in the loonie is a positive underpinning for many of our sectors, and again, that includes energy. There are a host of other Canadian companies in our portfolio that have U.S. dollar revenue streams in areas like real estate, banks, insurers and forest products, that are going to benefit from this renewed period of Canadian dollar weakness.

I can’t help but be as concerned as ever, in today’s ultra-low volatility and high complacency investment world, that there is very little in the way of anything possibly going wrong being priced into the riskiest and most cyclical asset markets. Now, I am far from advocating that anyone heads for the hills or move totally into cash just yet — there is always the danger of being way too early. But it is more a message to mold the portfolio into something that works more often than not late in the cycle, which is the opposite of how you would treat it in the early innings. The level of risk is just completely different and has to be priced as such.

While there may be more questions than answers, there are areas of conviction around which we can invest. No matter how good the news is, no matter how synchronized global growth may be, valuations in most risk assets already have this ebullience priced in. Central banks are changing direction and this augurs for less, not more, risk-taking, as liquidity growth slows and yield curves flatten or invert. Bank lending already is decelerating in North America, and regulatory shifts in Canada will reinforce this trend, keeping the BoC accommodative and the Canadian dollar vulnerable to recurring bouts of downward pressure (with or without the end of NAFTA). Financial conditions are very easy at the moment but, as history has taught us, these can shift very quickly. And it is the biggest bubbles — passive investing, leveraged ETFs, and the cryptocurrency mania — that will pay the biggest price. It would also seem probable that once the lags of higher interest rates begin to make their way through the system, the peak in global growth will be at hand, and that means that industrial commodity prices will either be contained or edge lower.

Although the vast majority of pundits and seers are very bullish on 2018 because of U.S. tax cuts, much of this is already discounted at an 18x forward P/E multiple for the S&P 500. And history tells us that there is an 80% chance that the House turns Democrat next November, and this will undoubtedly cast a cloud over the policy outlook during the second half of the year. While there is likely to be an initial boost to economic activity from the tax relief package, over time, the cumulative impact will be negligible after taking all the effects into account (as in the reaction from the Federal Reserve and simple fact that the tax cuts on the personal side are so regressive). In fact, the Penn Wharton Budget Model estimates that the lift to annual growth rates resulting from this legislation over the course of 10 years will be, at most, 0.1 percentage point. Finally, it will be no match for the overriding theme for the year of increasingly less-friendly central bank-induced liquidity.

No doubt the debate over inflation will be center stage, but with the Fed raising interest rates and shrinking its balance sheet alongside the already-evident decelerating trend in the monetary and credit aggregates, it is very difficult to see what the factors are that will generate any sustainable inflation pressure that would not have already occurred this cycle. Yes, tight labour markets may yet ignite a wage uptrend, but given the intense competitive environment, especially in the broad retail sector, any acceleration in labour costs will likely impinge more on lofty profit margins than on the pricing outlook. Not only that, but the productivity gains that are now showing through in the midst of this technological revolution — automation, AI, robotics and the shared economy — will likely keep unit labour costs, the root cause of inflation, flat or negative. So the risk is not really about inflation any more than it was in the late 1980s, the late 1990s or the mid-to-late 2000s, for that matter — the risk is the Fed’s perception of inflation and its willingness to be pre-emptive in a classically late-cycle setting.

To reiterate, while the bull market in equities isn’t over yet, we are in the very late stages and that means it is time to become a little more cautious. This is also true as far as the market for corporate bonds is concerned, and we expect a more challenging asset class performance in 2018 to create more periods of spread widening and price dislocation as liquidity becomes less abundant, which in turn will create more investment opportunities during the year. We fully expect leadership within the nonfinancial corporate space to be rather narrow, with challenges evident in retail, healthcare, telecom, and media. While North American credit markets are expensive, they do offer better value than their European counterparts. Both within the investment grade and high yield arena it will be very important to maintain minimal exposure to low coupon/long duration paper that is interest rate sensitive as the Fed continues to hike (homebuilders and rental companies come to mind and also are very expensive). As with the equity market, energy is one sector that we favour within the credit markets, though again, liquidity will be a very high priority as the cycle continues to mature.

In sum, we intend to remain defensive in 2018, fully expecting heightened volatility, and will seek out corrections in valuation to add exposure when yields move in favour of lenders instead of borrowers. This is one switch we expect will occur in classic late-cycle fashion in the coming year. This environment will be underscored by less generous liquidity provisioning by the major central banks with the Fed continuing to raise rates while shrinking its balance sheet, a new ECB leadership more prone to tapering, at least another hike out of the BoE and the People’s Bank of China’s efforts to deleverage the extremely debt-heavy Chinese financial system.

SO HOW TO INVEST IN 2018?

Answer: be aware of where we are in the cycle and construct your portfolio appropriately:

1. Reduce domestic cyclical exposure; focus more on global equities even as the trade gets more crowded — Japan is still underowned both globally and locally.
2. Focus on companies with strong balance sheets; low refinancing risks.
3. Screen more heavily on earnings quality and predictability; cut the overall beta of the equity portfolio.
4. Protect the equity portfolio by writing call options or buying puts.
5. Diversify geographically into markets that are in an earlier part of the cycle (many parts of Europe, Asia).
6. Step up exposure to dividend growth areas and to less economically sensitive parts of the market.
7. Credit hedge funds with attention paid to better quality should help preserve capital and provide a recurring cash flow.
8. Long-term bond yields never rise during a recession — so no matter how low they are, they can indeed go even lower unless this cycle goes to extra innings; if the Fed fully inverts or flattens the yield curve and growth slows sharply, high-quality long-duration bonds will be a nice escape valve.